Choosing the right Life Insurance plan

Life Insurance

In the previous two articles in our life insurance series, we had discussed how to determine how much life insurance cover you need and how to choose a life insurance provider based on various metrics. Each of the life insurance companies offers a variety of plans, so there are a large number of options to choose from. However, the insurance buyer needs to select the right plan which will meet his or her needs. In this article, we will try to analyze various types of life insurance policies in India, so that insurance buyers can educate themselves and make the right decision while buying insurance.

Types of Life Insurance

Based on features and the benefits, broadly five different categories of life Insurance products are sold in India

Term Insurance plans

Whole Life Insurance plans

Endowment Insurance plans

Pension Plans

Unit Linked Insurance Plans

We will discuss important features of each of these life insurance plans.

Term insurance

Term life insurance provides life insurance cover to the policy holder only for a specified term. Term insurance can be bought for any number of years as per the requirement of the policy holder. The life insurance cover expires at the end of the term. A default in a premium payment also ends the insurance cover provided to the policy holder. On expiry of the term the policy holder can renew the policy to extend the period for which the policy holder is covered. The nominee of the policy holder receives the cover amount or sum assured in the event of an untimely death of the policy holder within the policy term. However, if the policy holder outlives the term of the term insurance policy, then the policy holder does not get any maturity amount. Therefore there is no survival benefit for the policy holder.

Key Features

Life insurance at low cost (lowest premium to cover ratio)

No survival benefits. It is purely an insurance product

Premiums are eligible for deduction from taxable income under section 80C

Who should buy term insurance?

I am a big advocate for term insurance. A term insurance policy should be your first insurance policy. It is especially advantageous for young insurance buyers. The low cost structure of term insurance leaves the policy holders with a much bigger investible surplus that they can invest in other assets (like equities) that can give them far better returns in the long term and grow their wealth.

Whole Life insurance

A whole life insurance policy serves as an investment and offers protection for the entire life of a person or up to 100 years whichever comes earlier. Whole life plans helps the policy holders build tax exempt savings, while providing him or her life cover at the same time. A pertinent question at this point is why do I need whole life cover? Common logic would say that we do not need insurance after retirement, since there is no financial loss to the dependants in the event of death. The addition premium that the policy holder pays for whole life policy can be invested in assets that give better returns. The logic is very sound. However, there are several reasons that compel us to consider whole policies. The first reason is increased longevity. If you think that your dependent will outlive you by many years, and your retirement savings may not be sufficient to support her, then taking whole life insurance makes a lot of sense. You give up some income, but you can financially protect your dependants over their lifetime. The other reason is increasing healthcare costs. A long and serious illness that ultimately results in death, is not just emotionally distressful for the dependants, but expensive medical treatments also sets them back financially quite a bit, unless the medical expenses are covered by health insurance.

Key Features

Premiums are expensive (high premium to cover ratio). Amount of premium depends on policy holder’s age when they buy the policy and they continue to pay the premium as long as they live. Typically premiums for whole life insurance can be 10 to 15 times the premium of term insurance, for the same life cover

Premiums have two components, a risk cover component and an investment component

The policy holder is not entitled to any survival benefit during his or her own lifetime

Dependants of the policy holder gets sum assured in the event of death

Policy holders can take a loan against the cash value or draw it out at retirement

If the policy holder surrenders the policy, he or she gets the investment value along with the bonus accrued

Premiums are eligible for deduction from taxable income under section 80C

Who should buy whole life insurance?

Whole life insurance policies are suitable for typically middle aged investors with dependents. One can take a whole life insurance policy as a supplement to their term insurance plans. It also works a forced saving mechanism. It gives the policy holder the flexibility to surrender his or her policy if they are unable to pay the insurance premium during their retirement. The policy holder still gets the investment corpus along with accrued bonus of their whole life policy. However, investors should note that the returns in whole life insurance are low (5 – 6%). Whole life plans are more complex plans. The policy holder must seek clarifications on a number of policy features, like amount of premium that goes to risk cover, surrender policies and add on riders like disability insurance, critical illness insurance cover etc. Remember, more riders the insurance company adds, the more expensive is the premium

Endowment Insurance

Endowment plans are mixture of term and whole life insurance. In an endowment plan the policy holder gets a guaranteed amount (also known as sum assured) and a bonus amount on maturity. In the event of an untimely death, at any point of time during the term of the policy, the family of the policy holder gets the sum assured. The sum assured is almost equal to the total premium amounts paid over the entire term of the policy. Thus endowment plans are hybrid insurance and investment instruments. However, investors should note that return on investment in endowment plans is quite low. Historically, the returns were only in the range of 5 – 6%. There are more efficient investment options in the market.

Key Features

Premiums are expensive (high premium to cover ratio). Amount of premium depends on the age of the policy holder and the sum assured chosen by the policy holder. Typically premiums for whole life insurance can be 15 times or more the premium of term insurance, for the same life cover

Money back plans are a variant of endowment plans, where the insurance company returns a percentage of the sum assured at some regular intervals (e.g. 4 years or 5 years)

Dependants of the policy holder gets sum assured in the event of death

If the policy holder surrenders the policy, he or she gets a surrender value, depending on the number of years completed, the premium and the bonus received. The surrender value differs from policy to policy

Policy terms are complex which leaves room for misrepresentation. A wide variety of options in the endowment plans creates further confusion

Endowment plans are the most popular plans in India. I have often wondered why. It is probably because agents like selling endowment plans. Endowment plans can be a safe choice for very risk-averse investors. But in my opinion, it is not a very smart choice since the premium is very high. If investors can spend a little time in research, a combination of term insurance and mutual funds is a much smarter choice. The policy holder must seek clarifications a number of policy features, like the premium to risk cover ratio, surrender policies, participative features and add on riders. As discussed earlier, more riders the insurance company adds, the more expensive is the premium.

Pension Plans

A pension plan is a policy where the policy holder pays premium for a specified time frame and after a certain date, receives regular annuities. Therefore pension plans are also called annuities. The annuities are a source of regular income during the retirement of the policy holder. In case of any unfortunate demise of the policy holder, annuity savings are paid to the dependant or nominee of the policy holder. There a number of pension plans offered by Life Insurance companies. However a lot of these Pension Plans are very new and have no track record. These pension plans have much higher fund management costs (3 – 4%) compared to purely investment oriented pension plans, such as National Pension Scheme (0.25%) and the pension plans offered by mutual funds (2 – 2.5%).

Key Features

Pension plans give guaranteed income over the entire life of the policy holder

They have convenient annuity pay out options like monthly, quarterly, yearly etc

In case of unfortunate death of the policy holder, annuity savings are paid to the dependant or nomine of the policy holder

The returns of investment in pension plan is not very attractive

Premiums are eligible for deduction from taxable income under section 80C

Who should buy pension plans?

It may be suitable for middle aged investors with low risk appetite to supplement an existing retirement planning investment, while also getting the investor some additional insurance cover, should he or she need one. Investing through systematic investment plans in diversified equity funds, and then generating regular income in retirement through a systematic withdrawal plan may be a more efficient retirement planning option. Investors may choose to supplement their SIPs, with an insurance pension plan if they have additional savings and want to minimize risks going forward. But investors should note that the return on investment in pension plan is not very attractive.

Unit Linked Insurance Plans

Unit linked insurance Plans (or ULIPs) are essentially mutual funds with a life cover add on. ULIP is probably the most controversial investment product in the recent history. It was marketed aggressively by the insurance companies, and there was low awareness among investors about the fee structures. Under the revised IRDA guidelines the fees have been revised and ULIPs are now more attractive as investment option, than in the past. ULIPs are combined investment and insurance plans. The investors may choose between equity and debt allocations of their premiums, depending upon their financial planning considerations. ULIP also offers life cover of a minimum 5 times your annual premium (however investors can opt for higher life covers). ULIPs have a five year lock in period. The maturity proceeds from ULIPs are tax exempt under Section 10 (10D). In terms of gross investment returns ULIPs have performed comparably with mutual funds over a 5 year period, with top ULIPs giving annualized returns of 16 – 18%. However, net returns to investors would be very different due to various applicable charge structures (see below):

Premium allocation charges: While some companies offer zero premium allocation charges, on an average it is 7 – 8%. This would be deducted upfront, before the units are allotted

Policy administration charges: While it differs from company to company, it can range from 0.5 – 1.5%, of your premium amount

Mortality charges: It is the fee for your insurance cover. It depends on the age of the investor and the amount of cover. For example for a 30 year old, it can be Rs 1.3 – 1.4/- for Rs 1000 of sum assured

Fund Management charges: It is capped at 1.35% of the NAV, levied on the entire corpus

Surrender charges: If you are unable to pay the premium within the lock in period of 5 years, then surrender charges would apply for encashment of the units

Therefore one should read the product document very carefully to clearly understand the charges, before investing.

Key Features

Minimum investment period of 5 years

Premiums are very expensive (high premium to cover ratio). Therefore a sizeable portion of the premium goes to mortality charges and consequently there is less left to buy units

Flexibility of directing your savings as per your risk appetite

In case of unfortunate death of the policy holder, the dependant or nomine of the policy holder gets the life cover. Investors should clarify with their insurance agents how much life cover they will get, when they buy ULIPs

Features of both life cover and health cover

There are surrender charges if the investor surrenders the policy within 5 years

ULIPs are suited for younger investors with high risk appetite and a preference for liquidity. Since ULIPs invest in equity markets, the returns can be very volatile. Management costs of ULIPs are very high. Investors should not be surprised with negative returns in the first few years. Suffice to say, if you have relatively short term horizon, say 5 years, ULIPs will provide much lower returns than comparable mutual funds (e.g. equity linked saving schemes), due to the high charges discussed above. However, since the costs are front loaded, once they are paid in ULIPs can give good returns in the long term. In fact some ULIPs have given returns at par with mutual funds. In my opinion, a term insurance combined with a SIP in a tax saving mutual fund (e.g. ELSS), serves the same purpose as ULIPs. Investors and financial advisors should do a cost benefit analysis of both the options (term insurance + ELSS) and ULIPs, before deciding which option to select for insurance and wealth creation purposed.

Conclusion

In this article we have reviewed the different types of life insurance plans in India. At the cost of repetition, it is important point to keep in mind is not to mix insurance and investment objectives. Many of us will agree that there has been widespread mis-selling of insurance products in India for many years. Investors lacked the financial awareness and therefore were not able to make the right decision. At the core, insurance is all about providing financial security of your loved ones, in the event of an untimely death. But wealth creation is also an important financial objective. As with investing, educating yourself about insurance is essential to making the right choice regarding which life insurance policy to buy.

Dwaipayan Bose

An alumnus of IIM Ahmedabad, Dwaipayan is a Finance and Consulting professional, with 13 years of management experience, mostly in MNCs like American Express and Ameriprise Financial, both in India and the US. In his last role, he was the Chief Financial Officer of American Express Global Business Services in India. His key interests are building best in class organizations, corporate governance and talent development